The Hedging Corner: A No-Brainer and 2-for-1

In strategic, long-term hedging, there are few no-brainers. There are also few 2-for-1s. When they occur simultaneously, you seize the opportunity. It appears manufacturers have such an opportunity in natural gas, at least those manufacturers who plan to be around for a while and like cheap electricity and ethylene.

It's Cheap

Much Cheaper than Oil (WSJ, 3-Jun-11)

"Under the burden of the persistent supply glut, natural gas was among the worst-performing commodities in 2010. Prices of raw materials from crude oil to copper, and agricultural staples such as wheat and cotton, have all touched multiyear highs in recent months, but natural gas may be receiving a boost as investors look for cheaper physical assets. 'Natural gas has not really participated in these huge commodity moves,' a trader said. 'As an investor, do I want to buy oil at $100, or natural gas at $4.50?'"

Below Breakeven for Many Producers (WSJ, 23-May-11)

"In the past few years, a glut of natural gas has driven down the price to half the 2008 average. That's good news for consumers, but a recent study by consultancy Wood-Mackenzie found that 40% of U.S. natural gas produced last year didn't meet break-even prices for producers.

[At current prices] companies make more money drilling for oil. Companies use the same type of rig to drill for oil or gas, and allocate equipment according to which fuel is more profitable to produce. With natural-gas profit margins all but disappearing, companies are cutting back on new gas drilling just as demand is poised to increase. Despite weak prices, ExxonMobil Corp. and Chevron Corp. have acquired companies to expand their gas holdings, signaling they believe prices will rebound."

Demand is Strong and Growing

Ethylene from Natural Gas (WSJ, 25-Apr-11)

"The very thing that killed the U.S. chemicals industry is now reviving it: natural gas. Ethane, derived from natural-gas liquids is a primary ingredient for ethylene. When the price of natural gas spiked in the mid 2000s, mostly because of falling production, U.S. chemicals producers became uncompetitive and mothballed factories. Abundant shale gas has changed that, sending gas prices lower and keeping them there. NGLs have followed. They are now much cheaper than naphtha, an oil-derived alternative to ethane used mainly by European and Asian competitors. With oil prices so strong, the highest-cost naphtha-based plants produce ethylene for about $1200 a ton. Ethane-based U.S. producers' costs are now about half that."

Chevron, Shell, Dow, et al (WSJ, 13-Jun-11)

"Thanks to hydraulic fracturing, U.S. drillers are producing lots of ethane and propane (NGLs). Chevron-Phillips Chemical has plans to build a new plant in Texas that will provide components for the production of polyethylene. Dow Chemical has announced an expansion of its U.S. capacity to produce ethylene, and is constructing a new ethylene plant on the Gulf Coast. Dow's reason: competitively priced ethane and propane. Not to be outdone, Shell is developing plans to build a large ethylene plant in the Appalachian region."

Electricity Generation

Natural gas accounts for about a quarter of U.S. electricity generation, and its contribution is growing. Power companies are replacing coal-fired plants with gas-burning ones. Natural gas costs roughly the same as its energy equivalent in coal, and burns much cleaner. It is the incremental fuel for electricity generation and, therefore, sets electricity prices. (Price correlations are well over 90% across the U.S.) The EPA is trying to shut down coal-fired plants and make it virtually impossible to build new ones. After the tsunami in Japan, nuclear energy is toast. Germany (closing down 17 nukes by 2022) and now Italy are abandoning nuclear energy.

Shift for Diesel-Hogging Rigs (WSJ, 17-May-11)

"An 18-wheeler can burn as much fuel in a year as 40 cars. Congress, the natural-gas industry, and major trucking firms are promoting a federal bill to support the transformation [from diesel to natural gas]. Where natural gas is available at U.S. pumps today as a motor fuel, it typically costs about two-thirds the price of diesel after adjusting prices for energy content. If America could affordably manufacture natural-gas trucks and build enough fueling stations to keep them on the road, the economy could save billions of dollars a year in imported-fuel bills, backers of the technology say."

Supply is High, but Lizards and Water Rule!

No Oil Drilling in My Backyard (WSJ, 14-Jun-11)

"The dunes sagebrush lizard may knock out a big portion of the 'most prolific oil-producing region in onshore America' - the Permian Basin in West Texas and Southeast New Mexico."

No 'Fracking' around My Ground Water (WSJ, 20-Jun-11)

"The natural-gas industry, bowing to longtime pressure, will disclose more information about the chemicals it uses in the controversial process of hydraulic fracturing. Hydraulic fracturing, called 'fracking', involves blasting millions of gallons of water, sand, and chemicals into the ground to break up oil and gas-bearing rocks. The process has been used for decades, but become far more common in recent years and opened up huge new gas fields in Texas, Louisiana, Pennsylvania, and other states. [Extreme] environmental groups such as the Natural Resources Defense Council and the Environmental Defense Fund say chemicals from the hydraulic fracturing process are seeping into drinking water supplies. Drilling companies say chemicals make up less than 1% of the volume of most fracturing jobs and are mostly benign." [Now who do you suppose will win that conflict?]

Conclusion

If you want to guard against higher electricity rates in the future, buy natural gas. If you process ethylene or ethylene derivatives and want to ensure NGLs used to make them stay cheap for you, buy natural gas. It's a no-brainer and 2-for-1.

You can "buy" natural gas in several ways. Email me a request and I'll share some with you. 

About the author: Tom Langan is a risk management consultant who operates WTL Trading. He specializes in commodity cost control, margin improvement, and revenue expansion for manufacturers and their customers.